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2 Outline Emerging Markets & Developing Countries in the Global Financial Crisis The 3 rd capital inflow boom : Was it different?” The 3 rd capital inflow boom : Was it different?” Lessons of on avoiding crises: Did they hold up in 2008? Lessons of on avoiding crises: Did they hold up in 2008? Big emerging markets come of age in 2009 Big emerging markets come of age in 2009 Macroeconomics: decoupling Macroeconomics: decoupling Global governance: the G-20 replaces the G-7 Global governance: the G-20 replaces the G-7 The case of the RMB: sterilized intervention of inflows The case of the RMB: sterilized intervention of inflows Addenda Addenda Global current account imbalances Global current account imbalances Countercyclical fiscal policy Countercyclical fiscal policy

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7 Are big current account deficits dangerous? Neoclassical theory – if a country has a low capital/labor ratio or transitory negative shock, a large CAD can be optimal. In practice – Developing countries with big CADs often get into trouble. Traditional rule of thumb: “CAD > approx. 4% GDP” is a danger signal. “Lawson Fallacy” – CAD not dangerous if government budget is balanced, so borrowing goes to finance private sector, rather than BD. Amendment after 1994 Mexico crisis – CAD not dangerous if BD=0 and S is high, so the borrowing goes to finance private I, rather than BD or C. Amendment after 1997 East Asia crisis – CAD not dangerous if BD=0, S is high, and I is well-allocated, so the borrowing goes to finance high-return I, rather than BD or C or empty beach-front condos (Thailand) & unneeded steel companies (Korea). Amendment after 2008 financial crisis – yes, all CADs are dangerous.

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8 Lessons of the crises Many emerging markets after the 1990s learned to Many emerging markets after the 1990s learned to (1) float or hold large reserves or both (1) float or hold large reserves or both (2) use capital inflows to finance reserve accumulation (“self-insurance”), rather than current account deficits (2) use capital inflows to finance reserve accumulation (“self-insurance”), rather than current account deficits (3) take capital inflows more in the form of FDI or local-currency-denominated debt flows; (3) take capital inflows more in the form of FDI or local-currency-denominated debt flows; avoiding the currency mismatch of $ liabilities avoiding the currency mismatch of $ liabilities and avoiding short-term bank loans. and avoiding short-term bank loans. The ratio of reserves to short-term debt is the most robust predictor of crisis likelihood & severity. The ratio of reserves to short-term debt is the most robust predictor of crisis likelihood & severity. e.g. the Guidotti Rule: Keep ratio >1 e.g. the Guidotti Rule: Keep ratio >1

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10 Did those who obeyed the lessons of done better in response to the shock? Some who had large current account deficits & foreign-currency debts did have the most trouble, Some who had large current account deficits & foreign-currency debts did have the most trouble, particularly in Central & E.Europe: particularly in Central & E.Europe: Hungary, Ukraine, Latvia… Hungary, Ukraine, Latvia… Despite views of some economists that emerging market countries had been holding too many reserves, they appear to have turned out the ultimate insurance. Despite views of some economists that emerging market countries had been holding too many reserves, they appear to have turned out the ultimate insurance. Aizenman ( 2009): “The deleveraging triggered by the crisis implies that countries that hoarded reserves have been reaping the benefits.” Aizenman ( 2009): “The deleveraging triggered by the crisis implies that countries that hoarded reserves have been reaping the benefits.”

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11 Systematic studies are only starting. Obstfeld, Shambaugh & Taylor (2009a, b): Obstfeld, Shambaugh & Taylor (2009a, b): Finding: A particular measure of countries’ reserve holdings just before the current crisis, relative to requirements (M2), predicts 2008 depreciation. Finding: A particular measure of countries’ reserve holdings just before the current crisis, relative to requirements (M2), predicts 2008 depreciation. Current account balances & short-term debt levels are not statistically significant predictors, once reserve levels are taken into account. Current account balances & short-term debt levels are not statistically significant predictors, once reserve levels are taken into account. Rose & Spiegel (2009a, b) and Blanchard (2009) found no role for reserves in predicting who got into trouble. Rose & Spiegel (2009a, b) and Blanchard (2009) found no role for reserves in predicting who got into trouble. Frankel & Saravelos (May 2010): We get stronger results, because we consider crisis period to have gone thru March Frankel & Saravelos (May 2010): We get stronger results, because we consider crisis period to have gone thru March 2009.

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23 Conclusions from Frankel & Saravelos (May 2010) Early Warning Indicators were useful in predicting which countries were hit by the global financial shock, Early Warning Indicators were useful in predicting which countries were hit by the global financial shock, especially the most tried-and-trued EWIs: especially the most tried-and-trued EWIs: Reserves (e.g., as a ratio to short-term debt), Reserves (e.g., as a ratio to short-term debt), Preceding real exchange rate appreciation Preceding real exchange rate appreciation (relative to a long-run average RER). Among others that do the best: CA & Natl. Saving Among others that do the best: CA & Natl. Saving

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26 De-coupling turned out to be real after all at least with respect to East Asia, which has rebounded very strongly over the last year, at least with respect to East Asia, which has rebounded very strongly over the last year, after a sharp loss of exports over the preceding year, after a sharp loss of exports over the preceding year, from 2008 QI to 2009 Q I. from 2008 QI to 2009 Q I. China’s growth China’s growth has not only returned to its blistering pace of 10% has not only returned to its blistering pace of 10% but by now is a source of global growth but by now is a source of global growth because China is now a much larger share of the world economy than in the 1980s or 90s. because China is now a much larger share of the world economy than in the 1980s or 90s. India, Indonesia, & other Asian countries also weathered the global recession well, and are growing strongly. India, Indonesia, & other Asian countries also weathered the global recession well, and are growing strongly.

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29 The G-20 in 2010 Canada & Korea will host the summit meetings in June & November, respectively.

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30 The true significance of the G-20 in 2009 The G-20 accounts for 85% of world GDP The G-20 accounts for 85% of world GDP The developing countries are the ones with strong fiscal positions! The developing countries are the ones with strong fiscal positions! A turning point: The more inclusive group has suddenly become central to global governance, eclipsing the G-7, and thereby at last giving major developing/emerging countries some representation, A turning point: The more inclusive group has suddenly become central to global governance, eclipsing the G-7, and thereby at last giving major developing/emerging countries some representation, after decades of fruitless talk about raising emerging-market representation in IMF & World Bank. after decades of fruitless talk about raising emerging-market representation in IMF & World Bank.

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31 Four possible G-20 agenda items for 2010 Financial regulatory reform Financial regulatory reform Capital adequacy ratios should be higher, and less procyclical Capital adequacy ratios should be higher, and less procyclical Surcharges on banks with large liabilities. Surcharges on banks with large liabilities. Most stays at the national level: mortgages, exec.compensation… Most stays at the national level: mortgages, exec.compensation… Macroeconomic exit strategies Macroeconomic exit strategies Global imbalances between developing countries and industrialized Global imbalances between developing countries and industrialized US and China should both admit responsibility US and China should both admit responsibility US: the budget deficit is too big. Needs to be fixed. US: the budget deficit is too big. Needs to be fixed. China: RMB is too low. Needs to be unfixed. China: RMB is too low. Needs to be unfixed. Post-Copenhagen progress toward new agreement on climate change, ideally to take effect Post-Copenhagen progress toward new agreement on climate change, ideally to take effect 2012.

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32 1. It is inevitable that more power go to large-GDP/creditor countries than small. This is why the IFIs work better than the UN. This is why the IFIs work better than the UN. The problem is that China, India, Korea, Brazil, etc., are large enough to be included… Hence the G-20. The problem is that China, India, Korea, Brazil, etc., are large enough to be included… Hence the G-20. Two principles of multilateral institutions 2. Conversation is not possible with more than 20 in the room.

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33 Worked well for years, Worked well for years, with small steering groups with small steering groups and few demands placed on developing countries. and few demands placed on developing countries. Failed when developing countries had become big enough to matter, Failed when developing countries had become big enough to matter, but were not given enough role: but were not given enough role: Doha Round Doha Round Example: many rounds of trade negotiations under the GATT.

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34 Conversation is not possible with more than 20 people in the room. Delegates just read their talking points. Delegates just read their talking points. Latest evidence: The Climate Change CoP in Copenhagen Latest evidence: The Climate Change CoP in Copenhagen The UNFCCC proved an ineffectual vehicle The UNFCCC proved an ineffectual vehicle Incompetent management of logistics Incompetent management of logistics Small countries repeatedly blocked progress Small countries repeatedly blocked progress Obama was able to make more progress at the end with a small group of big emitters. Obama was able to make more progress at the end with a small group of big emitters. To be honest, the G-20 is too big (30). To be honest, the G-20 is too big (30). My recommendation: an informal steering group within the G-20. My recommendation: an informal steering group within the G-20.

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The Renminbi

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36 Attempts at sterilization where emerging markets have faced large inflows In early 1990s, Colombia, Korea, Indonesia and others tried for a year or two and then gave it up. In early 1990s, Colombia, Korea, Indonesia and others tried for a year or two and then gave it up. In the past decade, China successfully sterilized for some years … until In the past decade, China successfully sterilized for some years … until Now it is trying again. Now it is trying again.

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38 While reserves (NFA) rose rapidly, the growth of the monetary base was kept to the growth of the real economy – even reduced in Sterilization in China

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39 But to sterilize, the PBoC had to raise the reserve ratios required of banks and to raise lending rates while continuing to underpay depositors Source: HKMA, Half-Yearly Monetary & Financial Stability Report, June 2008

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40 In China had more trouble sterilizing the reserve inflow (as predicted) PBoC began to have to pay higher domestic interest rates PBoC began to have to pay higher domestic interest rates and to receive lower interest rate on US T bills and to receive lower interest rate on US T bills => quasi-fiscal deficit. => quasi-fiscal deficit. Inflation became a serious problem in Inflation became a serious problem in True, global increases in food & energy prices were much of the explanation. True, global increases in food & energy prices were much of the explanation. But But China’s overly rapid growth itself contributes. China’s overly rapid growth itself contributes. Appreciation is a good way to put immediate downward pressure on local prices of agricultural & mineral commodities. Appreciation is a good way to put immediate downward pressure on local prices of agricultural & mineral commodities. Price controls are inefficient and ultimately ineffective. Price controls are inefficient and ultimately ineffective.

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43 Three reasons why China should move to a more flexible exchange rate regime, in its own interest Excessive reserves ($2 ½ trillion as of mid 2010 ) Excessive reserves ($2 ½ trillion as of mid 2010 ) Though a useful shield against currency crises, by now China has enough reserves Though a useful shield against currency crises, by now China has enough reserves Harder to sterilize inflows over time, as it learned in Harder to sterilize inflows over time, as it learned in Attaining internal & external balance. Attaining internal & external balance. To attain both, need 2 policy instruments. To attain both, need 2 policy instruments. In a large country like China, the expenditure-switching policy should be the exchange rate. In a large country like China, the expenditure-switching policy should be the exchange rate. Along with expenditure-increasing policies (2009). Along with expenditure-increasing policies (2009). RMB undervalued, judged by Balassa-Samuelson relationship. RMB undervalued, judged by Balassa-Samuelson relationship.

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44 Longer-run perspective: Balassa-Samuelson relationship For every 1% increase in real income/capita (relative to US), prices increase.38% (relative) For every 1% increase in real income/capita (relative to US), prices increase.38% (relative) Prices of goods & services in China are low Prices of goods & services in China are low not just low relative to the United States (.23) not just low relative to the United States (.23) but also low by standards of Balassa-Samuelson relationship estimated across countries ( which predicts.36 ). but also low by standards of Balassa-Samuelson relationship estimated across countries ( which predicts.36 ). before Dec statistical revisions by IPC project before Dec statistical revisions by IPC project In this specific sense, the yuan was undervalued by an estimated 35% in 2000 In this specific sense, the yuan was undervalued by an estimated 35% in 2000 and is by at least as much today. and is by at least as much today. But doesn’t imply need for sudden change of this size But doesn’t imply need for sudden change of this size

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46 What about China’s currency reform announced in July 2005? China did not fully do what it implied, i.e., basket peg (with cumulatable +/-.3% band). i.e., basket peg (with cumulatable +/-.3% band). Frankel & Wei (2007) & Frankel (2009) estimates: Frankel & Wei (2007) & Frankel (2009) estimates: De facto weight on $ still very high in De facto weight on $ still very high in Little appreciation against the implicit basket, Little appreciation against the implicit basket, but appreciation against $ in 2007, as the basket gave substantial weight to the € which appreciated against $. but appreciation against $ in 2007, as the basket gave substantial weight to the € which appreciated against $. Beijing responded to pressure on exporters in 2008 Beijing responded to pressure on exporters in 2008 by switching back to a dollar peg. Just in time to ride the $ up in its year of reverse-trend appreciation ! by switching back to a dollar peg. Just in time to ride the $ up in its year of reverse-trend appreciation !

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47 The Beijing-Washington standoff was deftly defused April 1-9. was deftly defused April 1-9. The probable deal, saving face on both sides The probable deal, saving face on both sides US Treasury agreed to postpone report that was due to Congress April 15, thus saving China face. US Treasury agreed to postpone report that was due to Congress April 15, thus saving China face. I bet China announces a change in its currency regime, around June (SED & G-20 mtgs.), thus saving US face. I bet China announces a change in its currency regime, around June (SED & G-20 mtgs.), thus saving US face. The coming currency reform won’t amount to much more than the 2005 change. The coming currency reform won’t amount to much more than the 2005 change.

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50 The problem of global current account imbalances, especially the US CA deficit & China’s surplus, especially the US CA deficit & China’s surplus, was the most salient global macroeconomic issue on the eve of the financial crisis. was the most salient global macroeconomic issue on the eve of the financial crisis. Imbalances narrowed sharply in 2009; Imbalances narrowed sharply in 2009; the US deficit fell by almost ½ ; the US deficit fell by almost ½ ; China’s CA fell by almost ½. China’s CA fell by almost ½. Its trade surplus actually dipped to 0 in March Its trade surplus actually dipped to 0 in March Problem solved? Problem solved? The imbalances will now resume widening. The imbalances will now resume widening.

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53 The events of struck major blows against both interpretations of CA. Most of us in the unsustainability camp would have predicted that something like the US sub-prime mortgage crisis would cause a big fall in the $. Most of us in the unsustainability camp would have predicted that something like the US sub-prime mortgage crisis would cause a big fall in the $. Instead, the $ strengthened. Instead, the $ strengthened. Most of those in the sustainability camp had been arguing that the US has uniquely superior assets (corporate governance, securities markets, bank regulation…) Most of those in the sustainability camp had been arguing that the US has uniquely superior assets (corporate governance, securities markets, bank regulation…) Instead, the crisis showed the US system to suffer serious flaws Instead, the crisis showed the US system to suffer serious flaws of crony capitalism like other countries (Simon Johnson, Ragu Rajan) of crony capitalism like other countries (Simon Johnson, Ragu Rajan) or – worse – excessive deregulation (Joe Stiglitz) or – worse – excessive deregulation (Joe Stiglitz) The answer, for the moment: The $ and US Treasury bills still play unique roles in the world monetary system. The answer, for the moment: The $ and US Treasury bills still play unique roles in the world monetary system.

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54 When will the day of reckoning come? It didn’t come in 2008: The financial crisis caused a flight to quality It didn’t come in 2008: The financial crisis caused a flight to quality which evidently still means a flight to US $. which evidently still means a flight to US $. Nor in May 2010: The Greek debt crisis has demonstrated Nor in May 2010: The Greek debt crisis has demonstrated European policymakers still don’t have their act together, European policymakers still don’t have their act together, And the $ remains the safe haven And the $ remains the safe haven

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: Chinese warnings Premier Wen worries US T bills may lose value. Urges the US to keep its deficit at an “appropriate size” to ensure Premier Wen worries US T bills may lose value. Urges the US to keep its deficit at an “appropriate size” to ensure the “basic stability” of the $ (again on 11/10/09). PBoC Gov. Zhou, proposes replacing $ as international currency, with the SDR (March 09). PBoC Gov. Zhou, proposes replacing $ as international currency, with the SDR (March 09).

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57 As recently as June 2008, President Bachelet and Fin.Min. Velasco had the lowest popularity rating of any ministers since the restoration of democracy to Chile

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58 A year later, they had the highest popularity rating of any ministers Why?

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59 Developing countries in 2009, for the 1 st time, were able to run countercyclical fiscal policies: On a global scale, China’s fiscal expansion was the most important example. On a global scale, China’s fiscal expansion was the most important example. Chile ’ s institutional reform could be a model for all: Chile ’ s institutional reform could be a model for all: Structural surplus of 1% of GDP (reduced to ½ %, then 0) Structural surplus of 1% of GDP (reduced to ½ %, then 0) if economy is at full employment & price of copper at its long-run level. if economy is at full employment & price of copper at its long-run level. Estimates of full employment & LR price of copper are made by commissions of experts, not politicians. Estimates of full employment & LR price of copper are made by commissions of experts, not politicians. those that had wisely saved during the boom those that had wisely saved during the boom Often in the form of ForEx reserves or a SWF. Often in the form of ForEx reserves or a SWF.

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60 Further thoughts on macro policy in mineral-exporting countries “The Natural Resource Curse: A Survey,” forthcoming in Export Perils, edited by B. Shaffer (U.Penn. Press). March “The Natural Resource Curse: A Survey,” forthcoming in Export Perils, edited by B. Shaffer (U.Penn. Press). March The Natural Resource Curse: A SurveyMarch 2010The Natural Resource Curse: A SurveyMarch 2010 A Comparison of Monetary Anchor Options for Commodity-Exporters in Latin America and the Caribbean,” Myths and Realities of Commodity Dependence: Policy Challenges and Opportunities for Latin America and the Caribbean, World Bank, Sept A Comparison of Monetary Anchor Options for Commodity-Exporters in Latin America and the Caribbean,” Myths and Realities of Commodity Dependence: Policy Challenges and Opportunities for Latin America and the Caribbean, World Bank, Sept A Comparison of Monetary Anchor Options for Commodity-Exporters in Latin America and the Caribbean A Comparison of Monetary Anchor Options for Commodity-Exporters in Latin America and the Caribbean “Peg the Export Price Index: A Proposed Monetary Regime for Small Countries,” Journal of Policy Modeling, June “Peg the Export Price Index: A Proposed Monetary Regime for Small Countries,” Journal of Policy Modeling, June “Peg the Export Price Index: A Proposed Monetary Regime for Small Countries,”Journal of Policy Modeling “Peg the Export Price Index: A Proposed Monetary Regime for Small Countries,”Journal of Policy Modeling